Closed-end funds offer opportunity, warrant scrutiny

For most individual investors, the closed-end-fund marketplace is a minefield of confusing yet enticing opportunities. The majority of the industry’s 640 closed-end funds trade at a perpetual discount to their net asset value, while some (currently about 20%) manage to trade at a significant premium.

Consider, for example, the Pimco High Income Fund (PHK).

At more than $10 per share, the fund is trading 51% above its $6.73 net asset value.

For some investors, the appeal might be the fund’s 14.4%-per-share dividend distribution rate.

But what investors might not realize is that 27% of that dividend distribution is actually a return of capital, which means the fund’s assets are shrinking to pay the dividend. This further drives down the net asset value, potentially widening the gap between NAV and share price.

That share price, meanwhile, had increased by more than 200% from the March 9 market low, and more than 100% year-to-date, through last Thursday.

By comparison, the S&P 500 had gained 48% from the March low and 11% year-to-date.

The fund’s performance is in many respects a testament to its legendary manager, Bill Gross, co-chief investment officer of Pacific Investment Management Co. LLC.

“Clearly, investors are not looking under the hood to see how the income is being generated,” said Patrick Galley, chief investment officer at RiverNorth Capital Management Inc., which has $400 million in assets, primarily in closed-end funds and exchange-traded funds.

While it is hard to make a case against such lofty performance, to money managers such as Mr. Galley, the presence of huge premiums to NAV illustrates how inefficiency is created by unsophisticated investors.

BIG PREMIUM

Another extreme example of the creation of a wide premium by investor appetite is the Cornerstone Strategic Value Fund (CLM).

The fund’s $12.50 share price is almost 54% higher than its net asset value, and it is paying a dividend of almost 17%.

The fund, which is managed by Ralph Bradshaw of Cornerstone Advisors Inc., was up 138% from the March low and almost 90% year-to-date through last Thursday.

“A lot of times, retail investors are attracted to these dividend yields, and fund boards know they can’t cut the distribution or the investors will all bail,” Mr. Galley said.

Not only do individual investors make up the majority of all closed-end-fund initial-public-offering sales, but they also own 80% of the market.

Mr. Galley, who manages the $260 million RiverNorth Core Opportunity Fund (RNCOX), said his advantage is that he looks at the market differently than do most retail investors.

“You can’t just buy a closed-end fund and cross your fingers,” he said.

The RiverNorth fund, which was up more than 34% year-to-date through Thursday, buys closed-end funds trading at a discount, but with a catalyst, that will close that gap.

The fund’s performance compares with a 14.7% average gain by the moderate-allocation category as tracked by Morningstar Inc.

The closed-end-fund market virtually fell off a cliff last fall when the average discount got to 26%, which compares with a historical average of 4.5%.

Performance this year has narrowed those extreme discounts and attracted investors, said Cecilia Gordon, executive vice president with Thomas J. Herzfeld Advisors Inc., which specializes in closed-end-fund management and research.

“Leverage has helped the performance of closed-end funds this year,” she said. “And investors are very interested in the yield, but they don’t always focus on a fund’s discount or premium.”

Ms. Gordon said the strategy for the last few months of the year will be to wait for discounts to start to widen again. It is a seasonal pattern that is usually driven by tax management selling and the reshuffling of portfolios.

“We’re looking to buy when the discounts widen,” she said. “We usually recommend that you shouldn’t pay a premium, but you should instead look for a different fund, because a significant premium does make it a riskier investment.”

Herzfeld Advisors currently has a “buy” rating on less than 1% of closed-end funds and a “sell” rating on 31% of the funds.

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E-mail Jeff Benjamin at [email protected].